1. Why Do Firms Hold So Much Cash? A Tax-based Explanation Fritz Foley Harvard Business School and NBER Jay Hartzell The University of Texas at Austin Sheridan Titman The University of Texas at Austin Garry Twite Australian National University

2. Motivation In 2004, cash represented 10.5% of assets of Compustat firms Dollar values of holdings large for many firms Microsoft: $60bn, GE: $23bn, Exxon Mobil: $23bn, Pfizer: $20bn Understanding extent to which firms hold cash part of academic research agenda in finance for more than 50 years Work emphasizes transactions costs, difficulty of obtaining external finance, and agency considerations Existing work does not consider possibility corporate cash holdings reflect tax incentives faced by multinationals Tax burdens created incentives for MNCs to retain cash abroad (until AJCA)

3. Overview of Results Use 1982-2004 Compustat and BEA data Present four findings 1)Firms that face higher tax costs of repatriating earnings hold higher levels of cash 2)They hold this cash abroad 3)The cash is held by subsidiaries that face high tax costs of repatriating earnings 4)Sensitivity of subsidiary cash holdings to repatriation taxes is particularly pronounced for technology intensive firms but is not observed for financially constrained firms

4. Agenda Some literature and explanation of tax incentives Data Firm-level tests Within firm tests Conclusion

5. Some Previous Literature Cash holdings reflect trade-off between opportunity cost of holding liquid assets and potential cost of being short liquid assets - Baumol (1952), Tobin (1956), Meltzer (1963), Miller and Orr (1966), Karni (1973) - Mulligan (1997) finds economies of scale in cash holdings Cash holdings high when raising external finance is especially costly and when returns especially volatile - Precautionary motives for holding cash - Opler, Pinkowitz, Stulz, and Williamson (1999), Bates, Kahle, and Stulz (2006)

6. Taxation of U.S. MNCs U.S. taxes earnings of foreign incorporated subsidiaries when earnings repatriated - Tax credits given for foreign tax payments - Earnings of branches taxed as earned Taxes due upon repatriation roughly equal to difference between foreign income taxes paid and tax payments that would be due if taxed at U.S. rate - Worldwide averaging applies - Excess credits from one year can be carried back/forward The relevant U.S. rate reflects firm-specific considerations -For example, nols can be used to offset payments due on foreign source income -Argues for use of estimates of firm marginal tax rates in empirical work Passive income is deemed distributed and immediately taxable in the U.S. -Some discretion to classifying foreign cash holdings as being necessary -Subpart F provisions salient when considering where to hold liquid securities

7. Implications for Cash Holdings U.S. MNCs more likely to retain earnings in low tax jurisdictions - Hines and Hubbard (1990), Grubert (1998), Grubert and Mutti (2001), Desai, Foley, and Hines (forthcoming) Consider firm choosing to invest earnings from low tax jurisdiction in cash either in U.S. or in the low tax jurisdiction - Taxes often create incentive to hold cash abroad Imagine firm earns $100 and pays $20 in foreign taxes - If it repatriates, $15 is due in U.S. taxes and the remaining $65 can be invested, pay U.S. rate on income - If it invests abroad, pay U.S. rate on income but invest $80 because defer repatriation taxes

8. Alternative Hypothesis Repatriation tax costs could have no effect on cash holdings - Firms may retain earnings abroad, but increase investment and not cash - High repatriation tax costs could increase foreign cash holdings but decrease U.S. cash holdings - Various tax avoidance measures could make repatriation taxes irrelevant

9. Data 1982-2004 Compustat data covering firms with>$100mn in assets Information on aggregate cash holdings Data on foreign pretax income and foreign income taxes Can compute controls used in previous work BEA data from survey of U.S. Direct Investment Abroad Benchmark year data: 1982, 1989, 1994, and 1999 Covers U.S. cash holdings and cash holdings of each subsidiary Covers incorporated subsidiaries and branches (6.4% of sample) Can be used to estimate effective tax rates in host countries Marginal tax rates as estimated in Graham (1996b ) Main dependent variable Ln(Cash/(Assets-cash))

10. Tax Burden of Repatriation Tax Cost of Repatriating Earnings Max (0, US Rate X Pre-tax Foreign Income - Foreign Taxes Paid), scaled by total assets Use marginal and statutory US rates Appropriate if accumulated earnings proportional to current earnings, foreign tax rates similar to those charged when accumulated earnings taxed abroad Test if this proxy affect changes as well as levels of cash holdings Effective Repatriation Tax Rate Max (0, Weighted Foreign Tax Rate - US Rate) X Share of Activity Abroad Use Net PPE and Employment as weight and to measure activity Measure relates to stocks of activity, used to explain levels of cash holdings

11. Firm-level Tests Does the tax burden of repatriation affect consolidated cash holdings?

12. Figure 1 Median Cash/Net Assets

13. Table 2 A one-standard deviation in tax costs of repatriating earnings increases the ratio of cash to net assets by 7.9%

14. Table 3 The tax costs of repatriating earnings also affect changes in cash holdings

15. Table 4 Firms that face higher effective repatriation tax rates hold more cash

16. Firm-level Tests Does the tax burden of repatriation affect consolidated cash holdings? - Yes Do firms that face higher tax costs of repatriation hold more cash abroad? Do they hold less cash domestically?

17. Figure 2 Median share of cash held abroad

18. Table 5 Effective repatriation tax rates have effects on foreign cash holdings that are twice as large as their effect on domestic cash holdings

19. Table 6 Domestic cash holdings are lower for firms with higher effective repatriation tax, but the relation is not statistically significant

20. Affiliate-level Tests Does firms hold cash in subsidiaries that face higher tax costs of repatriation?

21. Table 7 Incorporated subsidiaries in low tax jurisdictions hold higher levels of cash The cash holdings of branches is not sensitive to host country rates

22. Affiliate-level Tests Does firms hold cash in subsidiaries that face higher tax costs of repatriation? -Yes Does the sensitivity of subsidiary cash holdings to host country tax rates vary with firm characteristics? Do firms that are financially constrained in the US exhibit a lower sensitivity? Do technology intensive firms exhibit a higher sensitivity? - High profits that can be shifted

23. Table 8 Sensitivity is lower for firms that have high domestic leverage and below investment grade or no debt rating Sensitivity is higher for technology intensive firms

24. Conclusion International tax incentives play an important role in explaining cash holdings US multinational firms that would trigger higher tax expenses by repatriating earnings have higher cash holdings These firms hold this cash abroad and hold it specifically in affiliates that face high repatriation tax costs - These firms hold this cash abroad -They hold the cash in subsidiaries that face high repatriation costs AJCA of 2004 intended to spur U.S. economic activity by temporarily reducing the tax costs of repatriations Beginning to study the effects of this act

25. Future Work How did firms respond to provisions of AJCA 2004 that temporarily reduced the tax costs of repatriation - Large sample analysis - Case study Do repatriation tax burdens affect M&A activity? Can we learn about the costs of obtaining external finance by studying which firms fund US projects through repatriations as opposed to raising new capital?